Supreme Court rules SEC use of in-house tribunals is unconstitutional

On June 27, 2024, the Supreme Court ruled in SEC v. Jarkesy that when the Securities and Exchange Commission (SEC) seeks civil penalties from defendants for securities fraud, the Seventh Amendment requires it to bring the action in a court of law where the defendant is entitled to a trial by jury.  The 6-3 decision ends the SEC’s long-running use of in-house tribunals led by Administrative Law Judges (ALJs) to adjudicate fraud actions. The decision is the latest in the growing trend by courts to curtail the reach of the administrative state, and is likely to have impacts far beyond the SEC.

New Ruling

The Supreme Court stripped the SEC of its ability to use in-house tribunals when seeking civil penalties against individuals accused of securities fraud. The Court held in SEC v. Jarkesy [1] that the Seventh Amendment entitles a defendant to a jury trial in such circumstances and that the SEC cannot force a defendant into internal administrative proceedings, which are held in front of ALJs instead of in federal court.

The decision is a culmination of years of significant pressure by defendants and the defense bar to expose the inherent shortcomings of the SEC’s administrative process.[2] In some ways, the decision is unlikely to have a significant immediate impact on the SEC’s charging decisions, as the agency had already changed its approach in anticipation of this ruling. The SEC has been, for the most part, limiting its use of administrative proceedings to settled cases. Litigated cases, except for those rare cases where the relief sought is not available in federal court, are generally brought by the SEC in federal court. While the contours of the decision are likely to be litigated in the coming years, the analysis the Court employed to reach this conclusion suggests Jarkesy may be a warning sign for other federal agencies which seek civil penalties through internal proceedings in front of ALJs instead of in federal courts.

Seventh Amendment Question

The defendants in Jarkesy claimed that by bringing a civil enforcement action against them for securities fraud and forcing the proceeding to an in-house SEC tribunal, the SEC violated the defendants’ Seventh Amendment right to a trial by jury. The SEC argued that Congress, when drafting statutes governing the SEC’s enforcement powers, delegated to the SEC the ability to pursue internally civil monetary penalties for violations of the securities laws, and that such a delegation does not violate – or even implicate – the Seventh Amendment.

Chief Justice Roberts, writing for the Court, first considered whether the SEC’s enforcement action implicated the Seventh Amendment. He explained that the antifraud provisions the SEC sought to enforce here replicate common law fraud, and noted common law fraud claims are traditionally heard by juries. Going further, the Chief Justice opined that historically, any action by the Government to recover civil penalties under statutory provisions was viewed as requiring trial by jury, and thus the Seventh Amendment was likely implicated by the civil charge of securities fraud.

Roberts then focused on the punitive aspect of the enforcement action. The Chief Justice noted that where a civil sanction does not serve a purely remedial purpose, but rather serves retributive or deterrent purposes, it is a punishment which can only be obtained through a court of law. Roberts then pointed to the six enumerated factors required to obtain civil penalties under the Securities Exchange Act of 1934 and the Investment Advisers Act of 1940, and noted that “several concern culpability, deterrence, and recidivism.” He concluded that “because they tie the availability of civil penalties to the perceived need to punish the defendant rather than to restore the victim, such considerations are legal rather than equitable.”

The Chief Justice concluded this portion of the analysis by stressing that because the civil penalties at issue “are designed to punish and deter, not to compensate,” they are therefore “a type of remedy at common law that could only be enforced in courts of law” and effectively implicate the Seventh Amendment right to a trial by jury. The analysis strongly suggests that any enforcement action by any federal agency that is designed to punish and deter an individual or entity violates the Seventh Amendment if it proceeds through agency tribunals and not federal courts, unless it falls into an exception involving “governmental prerogatives” – i.e., revenue collection, customs, immigration, public lands administration, and public benefits – which Roberts proceeded to curtail.

Limiting the “Public Rights” Exception

The Court then assessed whether the SEC’s securities fraud action falls within the “public rights” exception. This exception permits Congress to assign some matters to agencies for internal adjudications. Chief Justice Roberts listed a few categories of proceedings that fall under the public rights exception: cases related to relations with Indian tribes, administration of public lands, granting of public benefits such as payments to veterans, pensions, and patent rights. One common thread linking the Chief Justice’s examples is that none connect whatsoever to efforts to punish or deter individuals from violating federal laws, suggesting any agency that seeks a punitive penalty for violation of a federal statute does not come within the ambit of the public rights exception.

The Chief Justice noted that the Supreme Court’s “opinions governing the public rights exception have not always spoken in precise terms,” and stressed a need to limit overuse of the public rights exception or risk that the exception would “swallow the rule” that the Constitution generally prohibits Congress from withdrawing from judicial cognizance any matter which, from its nature, is the subject of a suit at the common law. Roberts concluded this aspect of the analysis by explaining that in circumstances where enforcement remedies include civil penalties for the same basic conduct that is covered by a claim under common law, then the enforcement action involves a private, rather than public, right and is not covered by the exception. Chief Justice Roberts ended the majority opinion in Jarkesy by emphasizing that a “defendant facing a fraud suit has the right to be tried by a jury of his peers before a neutral adjudicator.”

Broad Implications

After the Jarkesy ruling, the SEC is unlikely to litigate any securities fraud matters before ALJs that operate within the SEC. Instead, each investigative matter arising from alleged securities fraud will have to be handled by SEC staff with the understanding that, if settlement is not achieved, the case will go before a federal judge and a jury. In reality, the SEC has been operating in this way for years now, as the Supreme Court has questioned the constitutionality of the appointment process of SEC ALJs,[3] and as Jarkesy and other securities defendants have challenged the ALJ process in court. But the Jarkesy ruling now confirms, once and for all, that the SEC must use the federal courts to litigate its fraud cases and cannot rely on an internal forum that many believe is “rigged” in the SEC’s favor.[4] Moreover, the fallout from this decision will force the SEC to make decisions about the approximately 200 open administrative proceedings[5]—many of which have been pending for years while the SEC awaits the Supreme Court’s decision and thus may have passed the statute of limitations period to be brought as civil actions in federal court.

As noted above, the contours of the Court’s ruling in Jarkesy are not immediately clear and will likely be subject to further litigation in the coming months and years. First, courts will likely have to determine whether the right to a jury trial attaches to all punitive enforcement actions taken by the SEC, or merely actions that resemble historic common law claims like fraud. If courts determine the latter to be the case, then they will have to determine which enforcement actions sufficiently resemble common law fraud claims such that a right to a jury trial attaches. For example, courts may consider whether violations of regulations governing attorney and accountant conduct resemble common law professional malpractice claims to the degree that a right to a jury trial attaches to an enforcement action for those violations.

Second, the Supreme Court’s treatment of the Fifth Circuit’s holding leaves it unclear how much of the lower court ruling remains in force.[6] Before the Supreme Court granted certiorari in Jarkesy, the Fifth Circuit held that the SEC’s in-house tribunal system was unconstitutional on three separate grounds. First, it concluded that the in-hoes process violated the Seventh Amendment’s right to trial by jury. Second, it held that Congress violated the nondelegation doctrine by delegating the authority to enforce securities laws to the SEC, an adoption of a legal theory which would radically reshape most federal administrative agencies. Third, it held that legal restrictions on the ability of Executive Branch officials to remove ALJs, which allow dismissals only when they are “for cause”, also violated separation-of-powers principles under Article II of the Constitution. The Supreme Court affirmed the Fifth Circuit ruling only as to the first conclusion that the SEC’s in-house tribunal system violated the Seventh Amendment. The Court expressly acknowledged – but refused to address – the two other holdings of the Fifth Circuit, noting that because the right to jury trial question resolved the case in its entirety, the Court “did not reach the nondelegation or removal issues.” Because the Court did not expressly affirm or reject those aspects of the Fifth Circuit ruling, those questions will likely continue to be litigated.

Third, it remains to be seen to what extent Jarkesy impacts the SEC’s ability to bring claims that are available only in an administrative proceeding, and not in federal court, such as failure to supervise claims or “causing” violations, if those claims involve civil penalties. Even if Jarkesy is held to allow for such claims to be litigated before ALJs, the SEC may end up filing more bifurcated actions, where, for example, the SEC brings an action against primary violators in federal court and a separate “causing” action against the secondary violators in administrative proceedings.

Finally, the Court’s reasoning in Jarkesy will likely have consequences beyond the SEC. Justice Sotomayor stressed in her dissent that “momentous consequences” likely flow from “the majority’s insistence that the Government’s rights to civil penalties must now be tried before a jury in federal court.”[7] She noted that Congress has enacted countless new statutes that empower federal agencies to impose penalties for statutory violations, and that there are “more than two dozen agencies” that impose civil penalties in administrative proceedings. These agencies include the Commodity Futures Trading Commission, the Consumer Financial Protection Bureau, the Department of Justice, the Environmental Protection Agency, the Food and Drug Administration, the Federal Trade Commission, Immigration and Naturalization Service, and the Office of Foreign Assets Control. In light of Jarkesy, it is possible these federal agencies will reassess their use of ALJs or in-house tribunals and may be reluctant to use them for any enforcement action that seeks punitive remedies for violations of the law or bears a strong resemblance to common law claims.

Endnotes